A 3% Down Payment Sure Does Sound Attractive…

DISCLAIMER: This post is for people (like me), who know absolutely nothing about buying and financing a home.

A 3% down payment sure does sound attractive…. however, think carefully before you leap. Last month, two government-backed mortgage giants, Fannie and Freddie, announced a new loan program targeting first-time home buyers.  Under the program, a buyer could put down as little as 3% for a home. (So in theory, if you wanted to buy a $300,000 home, under this program, you’d only have to put down $9,000 – a down payment that is massively smaller than paying the traditional 20% down payment at $60,000. And yes, the latter takes years to save up for).

Several respectable media outlets covered the news, including the Washington Post, USA Today, AOL and TIME. When I first saw the headlines, I’d be lying if I said I wasn’t immediately hooked. If the new program is as good as it sounds, why the hell wouldn’t I buy?? Luckily, my parents raised me to be… suspicious.

However, without knowing anything about mortgages, finding the “catch” in the stories referenced above wasn’t easy. Which is a shame, because journalism owes it to the public to be more thorough and objective.  The stories all noted that under the new program, first time buyers would have to pass strict criteria, including good credit scores (620-650+) and completion of a home-buying education program. Easy enough.

But after digging more deeply, I came across this Consumer Affairs article that finally, more clearly identified the “catch.” Reporter Mark Huffman points out:

Because of the small down payments, these loans will also require private mortgage insurance (PMI) or other risk sharing. On a 3% loan, consumers should expect to pay a little over 1% of the loan as premium. In our example of a home costing $130,000 with $3,900 down, PMI would add about $110 to the monthly house payment.

Finally, a better picture of what a small down payment actually means for buyers! Thank you, Mr. Huffman. To make this a more realistic scenario (since $130k homes are rare in Chicago), that means for anyone interested in buying a $300,000 home, PMI could cost $3000 a year or $250 monthly on top of regular mortgage payments. (Note: This is money that is just paid and lost; it goes nowhere). Not to mention that a small down payment significantly drives up the monthly cost of your mortgage.

After digging even further, I found another helpful article that details another reason why first-time home buyers should avoid PMI. In addition to the cost, it talks about the negative tax consequences PMI has for couples who earn more than $110,000 annually together or $55,000 annually separately. Check it out here.

While I don’t want to automatically write off programs that accept small down payments, the moral of the story is to research, research, research! Otherwise, maybe we’d all end up like this individual:

… I was very ignorant when I purchased my 1st house at 25 years old! A combination of empty/mis-leading promises from my mortgage broker and just being so excited to be a homeowner got me into SERIOUS financial trouble!

I have been in my home for almost 5 years and have been paying $500 per month in PMI. I was told it would automatically end after 2 years. My monthly mortgage payments are about $1700 per month with PMI for a little two bedroom townhouse in Hudson, WI.

You can read the rest of this person’s story here, but you get the idea. Although a 3% down payment sounds wonderful on paper, it would take a lot of research and math to figure out if it’s actually worth doing over renting and/or saving for a more traditional down payment.

Thoughts?

 

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One thought on “A 3% Down Payment Sure Does Sound Attractive…

  1. L7

    Interesting article. I agree, many individuals who have not yet begun the home-buying process are basically in the dark when it comes to PMI. You’ve painted a very negative picture of PMI above; however, I wanted to play devil’s advocate here to illuminate the benefits of PMI.

    First, there’s a few different types of private mortgage insurance, so I’ll give a short overview. There’s borrower-paid mortgage insurance (BPMI), lender-paid mortgage insurance (LPMI), and other variations. BPMI is what your article above is referring to, and is more beneficial if the buyer(s) plan to stay at the home for a longer duration 10+ years. LPMI, is a bit different. The mortgage insurance is actually added to the interest rate. In effect, it raises the interest rate, however, the monthly payment of the LPMI / interest rate combination would be lower than the BPMI + mortgage payment (because, the BMPI can eventually go away). The downside is that the LPMI never goes away, and it may be more difficult to refinance (e.g., minimum # of years before a refi is allowed), which is why it is only recommended for those planning to resell the home in the not-so-distant future (e.g., rehab and flip, live in temporarily during college, etc.). Here’s more detail of LPMI vs BPMI: https://www.wellsfargo.com/mortgage/loan-programs/lender-paid-mortgage-insurance/ The other PMI options include some type of balloon payments (e.g., an upfront amount to cover PMI for a specific period of time), these could have tax benefits, but are atypical.

    BPMI is the most common choice of buyers who are not able to put down the 20% required by most lenders, so I’ll just be referring to it generically as PMI hereafter. In the current economic landscape, home prices have rebounded over the past few years, but they’re typically not as high as they were a 10-15 years ago. Further, the interest rates on conventional 30-year fixed loans (the most common type of mortgage) are still EXTREMELY low. In other words, it is still an EXCELLENT time to make a purchase. Many potential buyers, however, do not have requisite down payment of 20%, which is where PMI becomes an advantage. A lender is always concerned about one thing, its investment; and really, who could blame them. PMI ensures that if a buyer only puts down $10k on a $300k purchase (about 3%), that a lender will be made whole (or close to whole) in the event that a buyer defaults. $10k would never cover the cost of the foreclosure process, reselling the home, etc. Therefore, by paying PMI, a buyer can lock in a low interest rate. Typically, most lenders treat PMI like a staircase, where at certain intervals 5% equity, 10% equity, 15% equity, 20% equity, there’s a step down in the amount of PMI paid monthly. Then, at the 20% equity mark, the buyer requests a new appraisal (couple hundred bucks), ensures they own 20% equity, and the lender would remove the PMI requirement.

    What buyers must consider, however, is the opportunity cost of waiting to purchase to avoid the PMI requirement. As mentioned above, interest rates are really at all time lows (see this link: http://www.freddiemac.com/pmms/pmms30.htm). Many experts are predicting that the rates will rise from 3.99% to 4.75% by the end of 2015 (see this link: http://www.washingtonpost.com/news/get-there/wp/2015/01/05/where-interest-rates-are-going-in-2015-and-what-it-means-for-your-loans/ ).

    So, lets do some math. Assuming a person was putting down 3% on a $300k home, at a 3.99% interest rate, and 1% in mortgage insurance per year, their payment would be (not counting property taxes or home owners insurance) $1,640 / month. If the interest rates do go up to 4.75%, that monthly payment would increase to $1,770. In other words, if it only took 1 year to save up to that 20% down payment, then a buyer would avoid the $250/month in PMI, but would be stuck with a mortgage payment that is likely $125 or so more than what they would’ve paid a year earlier. A savings, yes, but if a buyer was that close to the 20% level their PMI wouldnt be very high anyway. Considering the history of interest rates over the years, though, its not out of the question that the rates are back in the 7% range in about 5 years, which would equate to a $2,190 monthly payment for that same $300k home ($400 increase).

    My point, really, is that paying PMI is likely a less costly (and definitely, less risky) proposition than waiting to save up for a 20% down payment (for X # of years) and potentially pay a much higher monthly mortgage payment as a result of a higher interest rate. Further, for anyone currently paying rent, $$ are already flowing out the door without any equity received in the property (similar to what many consider paying PMI to be). This is why many experts advise buyers to buy the best possible home that they can afford, as interest rates are not likely to be this low again in a person’s lifetime (and a subsequent home purchase to upgrade to a larger property in 5-10 years would likely carry a loan with a much higher interest rate), property is one asset that has historically (aside from the crash 5 or so years ago) retained or increased in value, and a person’s annual income typically increases annually to make the costs of home ownership more palatable as the years go on.

    Like

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